What is depreciation recapture?

1 min readLast updated November 10, 2023by Rachel Carey

Depreciation recapture involves dividing and spreading out the cost of an asset over several years of its life and benefiting from a tax deduction for that amount in each of these years. So, how exactly does it work in practice, and can you avoid it? We take a close look.

Firstly, what exactly is depreciation? 

Understanding how depreciation works in the context of tax is important before diving into depreciation recapture. As a business or taxpayer, you can use depreciation to write off the value of a fixed asset you’ve bought. The value this asset loses over time is its depreciation expense. If your asset depreciates gradually – instead of all at once – you can still earn revenue and enhance your net income, making the investment more profitable.  

But always remember, it’s the IRS who makes the rules. They decide on the depreciation schedule, the deduction rate and the deduction term. They will also be waiting to collect those taxes when you finally sell the asset.  

How is depreciation recapture used? 

As we’ve mentioned, certain capital assets, such as your home or another real estate investment, can be depreciated for tax purposes, allowing you to get tax deductions for that depreciation. By dividing the cost of an asset over several years and taking a tax deduction each year, you are depreciating the asset and lowering your tax burden

Companies do this to account for wear and tear on property, plant and equipment, dividing the cost of using these assets over their useful working life. 

The catch comes when you decide to sell the asset. By taking a deduction each year, you’ve reduced the asset’s depreciation-adjusted cost basis, which can increase how much tax you finally have to pay.  

So, while depreciation can be a useful way to cut your tax year-on-year, it can also leave you with a tax bill later because any gains you make by selling your asset once it’s been partially depreciated could earn you more than you anticipated and this can be taxed as ordinary income. 

How do you calculate depreciation recapture? 

You calculate depreciation recapture by taking the adjusted cost basis – the original price of your asset minus any allowable depreciation expense – and subtracting it from the sale price of your asset. 

Here is an example of depreciation recapture: 

  • The adjusted cost basis is $2,000, and you sell the asset for $3,000. You have gained $1,000, and this is now taxable 

  • The rate at which this gain is taxed will depend on your personal income tax rate and whether the asset is real estate 

Here’s another more complex example: 

  • You buy business equipment for $30,000 – this sum is your cost basis 

  • The IRS gives you a deduction rate of 15% over four years 

  • This would provide you with deductible expenses of $4,500 per year over the period 

  • To work out the adjusted cost basis, you’d multiply your yearly deduction cost by four, then subtract this figure from your cost basis. In this example, this would be $12,000 

  • If you then sold the asset for $13,500, you would be left with a realized taxable gain of $1,500 

If you made a loss at the point of your depreciated asset’s sale, you wouldn’t be able to recapture depreciation. Remember that gains and losses are calculated using the adjusted cost basis, not the original purchase value. 

When you file your taxes, the IRS will treat your recapture as ordinary income. They’ll also compare your asset’s realized gain with its depreciation expense. The smaller of the figures is the depreciation recapture. 

Can you avoid depreciation recapture? 

The short answer is no. Not if you record a gain on the sale of an asset on which you recorded depreciation. It doesn’t matter if you took the depreciation when it was available or not – the IRS will still tax you on the recapture. The only scenario where you can legitimately avoid depreciation recapture is if you sell your asset for a loss or trade it in for “like-kind” property of a similar value. 

For this reason, you should generally claim depreciation on your asset and get the tax deduction as it’s owed to you. You’ll have to pay tax on the gain due to depreciation when you eventually decide to sell it. 

Some key takeaways 

Here are some of the most important points to help you get to grips with depreciation recapture: 

  • Depreciation recapture is the IRS’ way of recouping taxes from deductions made for the depreciation of an asset that you sell 

  • It can have a big impact on the sale of residential real estate 

  • Usually, the depreciation capture tax rate is 25% 

  • A like-kind exchange is a good way to avoid paying depreciation recapture 

This is quite a complex area of taxation law, and it would make very good sense to seek the expert help of a financial advisor before you decide on a strategy. Reach out to Unbiased today to connect with a financial advisor who can listen and offer advice based on your circumstances.   

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Senior Content Writer

Rachel Carey

Rachel is a Senior Content Writer at Unbiased. She has nearly a decade of experience writing and producing content across a range of different sectors.